5 things you should know before buying a mutual fund

The mutual fund business is a great industry — for the people that sell them. For investors, it’s not so good.

Sure, mutual funds offer some advantages, such as “professional” management and diversification. However, there are plenty of bad things about the industry as well, things that potentially work to severely hurt investors.

No one, of course, ever talks about the bad side, as it is just too profitable for those employed by the investment industry money machine. Since I spent 20 years as a mutual fund portfolio manager but no longer work in the industry, here are five things investors should know before they buy another mutual fund.

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1. Fees
How best to put this? Here’s a simple analogy: Suppose you had a teenage son, who was a slightly above average hockey player. Would you encourage him to drop out of school, buy an Audi R8 Spyder and wait for the NHL money to roll in? Of course you wouldn’t.
But in the mutual fund world, if you are consistently a slightly above average mutual fund manager, you are an absolute superstar.
Because of fees, so few managers can actually beat the market over any lengthy period of time. Indeed, 95% of mutual funds managers simply cannot beat the index over the long term, because of fees. The few that can become the Gretzkys of the investment business, even if their funds are only slightly better than the market’s return.
Paying 2.5% in annual management fees when expected returns are just 5% or 6% is ridiculous, especially these days. Why should a manager make half of the returns that you do considering he/she won’t even beat the market? It simply makes no sense at all. Investors are far better off doing it themselves or investing in an ETF instead.

2. Short-term focus
This is a big problem in the investment industry overall. Mutual funds report portfolio returns on an annual basis, and clients hone in on one-year returns. Thus, if a manager is having a bad year, he/she will often change strategy in the middle of the year in order to save their annual performance.
This one-year focus prevents managers from thinking long term and adds extra transaction costs. One reason Warren Buffett is so successful is that he truly thinks long term. Mutual fund managers, on the other hand, are often actively encouraged not to.

3. Bonuses encourage gambling
The investment industry pays very well, but most of the compensation to managers is in the form of bonuses. As a result, managers are highly incentivized to gamble if their fund performance is bad.
Having a bad year? Well, to save your large bonus as a manager, you simply have to take more risks with your fund. If the gamble works, big bonus time. And, similar to point No. 2, since bonuses are tied to annual performance, even more gambling with investment funds is often done unnecessarily.
Very, very few mutual fund companies have bonuses that are based on long-term investment performance.

4. Asset gathering overrules fundamentals
A fund manager’s priority is to bring in money. Most managers will never say anything bad about the stock market. Even if the market is plunging and a giant recession is looming, a manager’s goal is to keep investors calm and get more money in the door.
Thus, a manager is discouraged from telling the truth about how they feel. If a portfolio manager ever said, “Hey, don’t buy my fund, the market is going down,” they would likely get severely admonished by their boss.
It is all about marketing, and sometimes the truth is wildly stretched to bring in more money.

5. Excessive deal buying and stock trading
In the portfolio manager business, information is key. The manager wants to get the first call from analysts and brokers, not the 23rd call.
How do managers ensure they are near the top of the call list? Mostly by buying lots of deals and trading lots of stocks. This ensures a nice commission flow to the brokers, who then show their appreciation by calling the manager with ideas more promptly.
The end result? Plenty of deal buying, trading and associated costs in a mutual fund without much net benefit to investors, after costs and trading spreads are accounted for.

Next time you see some slick mutual fund marketing or commercial, remember these negatives. There are lots more, too, which we will get to in another article.

Peter Hodson, CFA, is CEO of 5i Research Inc., an independent research network providing conflict-free advice to individual investors (www.5iresearch.ca)

Active Investor was produced by Postmedia's advertising department in collaboration with iShares by BlackRock to promote awareness of this topic for commercial purposes. Postmedia's editorial departments had no involvement in the creation of this content.

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